Classification shifting

My thesis focuses on the impact of changes to accounting standards that affected the scope for opportunistic classification shifting. Earnings management through classification shifting typically refers to the deliberate misclassification of items within the periodic income statement, in an attempt to increase core earnings (McVay 2006). As noted in Chapter One, ‘core earnings’ refers to measures of earnings from recurring normal business activities which exclude non-recurring and non-operating activities (i.e. extraordinary activities) and activities that might be attributable to normal operations but are considered abnormal by reason of their size and effect on the results in the period (i.e. abnormal activities).45 Managers manipulate core earnings because market participants (e.g. analysts and investors) pay more attention to core earnings than bottom line GAAP earnings, and core earnings are more closely aligned with equity 45 _{McVay (2006) defines core earnings as sales – cost of goods sold – selling, general, and administrative} expenses (excluding depreciation and amortisation). The measure of core earnings employed in my thesis differs from McVay (2006) in that the ‘non-core’ items excluded from its sum are implicitly those identified by the Morningstar analyst following the firm, rather than by direct reference to the amounts reported on the face of the firms’ income statement, and as such these items may have been reported on the face of the income statement or in the notes to the accounts. I discuss this in detail in Chapter Four.

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values than non-core earnings (Bhattacharya, Black, Christensen, and Larson 2003; Gu and Chen 2004; McVay 2006; Hsu and Kross 2011). This section discusses how earnings are managed through classification shifting.

3.5.1.1 How earnings are managed through classification shifting

Research documents that firms manipulate the positioning of income statement items in an attempt to influence user judgment of firm performance. In general, the further (closer) an income statement line item is from (to) sales, the less (more) persistent the item tends to be (Lipe 1986; Fiarfield, Sweeny and Yohn 1996), and there is evidence that investors price each line item differently (e.g. Elliot and Hanna 1996; Francis et al. 1996; Davis 2002; Bradshaw and Sloan 2002; Riedl and Srivinasan 2010). For instance, abnormal/special items reported below profit from operations are typically excluded from measures of ‘street’ earnings used by analysts and other users (Lougee and Marquardt 2004), because they are considered to be less value relevant (Ali and Zarowin 1992; Elliott and Hanna 1996; Bradshaw and Sloan 2002). Management may take advantage of market participants’ fixation on core earnings to misclassify (i.e. shift downward) recurring operating expenses as non-recurring expenses, or misclassify non- recurring gains (i.e. shift upward) as recurring operating revenue (McVay 2006). For example, early studies report that US firms reclassify operating losses and gains as extraordinary items, or extraordinary gains and losses as ordinary items to smooth earnings (Ronen and Sadan 1975; Barnea et al. 1976). Moreover, Kinney and Trezevant (1997) show that managers wishing to highlight the transitory nature of expenses are more likely to show income-decreasing special items as line items on the income statement, whilst income-increasing special items are more likely to be reported in the notes to financial reports. Johnson, Lopez and Sanchez (2011), document that the frequency, magnitude and persistence of negative special items increased significantly over thirty years (1980-2009).

The use of classification shifting as a tool to manage earnings has been brought to greater academic attention by the work of McVay (2006), who developed empirical models designed to detect abnormal behaviour in core earnings and correlated unexpected core earnings with the incidence of special items. She documents that managers opportunistically shift items from core expenses (i.e. cost of goods sold, and selling, general and administration expenses) to special items to improve core earnings. Other recent studies apply the McVay (2006) model in different environments,

producing further evidence of classifications shifting. Fan et al. (2010) show that firms classify core expenses as special items more often in the fourth quarter than in other quarters, to increase core annual earnings when accrual-based earnings management is constrained by prior accrual-based earnings management. Lin et al. (2006) examine a portfolio of earnings management choices and management guidance of forecasts and find that firms misclassify core expenses as special items more frequently, compared to using any other methods (although managers use all three types of earnings management). Lail et al. (2014) also report that firms shift expenses from core segments to other segments to increase core earnings. Siu and Faff (2013) find that SEO issuers also misclassify core expenses as special items in addition to accrual-based earnings management in order to increase core earnings in the fourth quarter. In a non-US study, Haw et al. (2011) report that firms across East Asia with controlling shareholders, opportunistically classify core expenses as income-decreasing special items.46

There is also evidence that the use of classification shifting reflects changes in regulations relating to the scope for the classification of non-recurring components of earnings. For example, Barua, et al. (2010) find that firms shift operating expenses to income-decreasing discontinued operations, and the frequency of reporting discontinued operations has increased since the introduction of SFAS 144. Also, Athanasakou et al. (2008) report that following the implementation of FRS 3, a subset of large UK firms shifted core expenses to other non-recurring items to improve core earnings. Preliminary evidence in Australia by Houghton (1994) and Cameron and Gallery (2008) show that firms classified and reported items as abnormal more frequently after the AASB 1018 was amended in 1989 to tighten the definition of extraordinary items.47 3.5.2 Earnings management using discretionary accruals manipulation

The importance of accruals in accounting has been well documented in the literature. Accruals adjust for the effects of transitory cash flows and thereby improve earnings’ ability to measure firm performance (Dechow 1994; Dechow, Kothari and Watts 1998; Dechow and Skinner 2000; Dechow and Dichev 2002; Francis et al. 2004), improving value relevance and contracting utility (Dechow 1994; Subramanyam 1996; Dechow and Dichev 2002; Ball and Shivakumar 2006). The inclusion of accruals in reported

46 _{Hsu and Kross (2011) provide evidence that firms also shift positive special items to core earnings} when accrual levels are low, hence, classification shifting does not only involve negative items but also positive items.

47 _{Refer to Chapter 2 for discussion of the regulations mentioned: SFAS 144, FRS 3 and AASB 101.} 65

earnings allows scope for managers to use their discretion in the recognition of these items to either signal their private information (consistent with the informational perspective) (Dechow 1994; Subramanyam 1996; Degeorge et al. 1999; Kangaretnam et al. 2004; Louis and Robinson 2005) or to opportunistically bias earnings (consistent with agency theory) (Dechow 1994; Dechow and Skinner 2000; Jensen 2005; Revsine et al. 2005; Baderstcher 2011). If managers exercise their discretion to manage accruals opportunistically in order to influence earnings, stakeholders are at risk of receiving unreliable information that impairs their ability to predict future cash flows (Teoh, et al. 1998; Badertscher et al. 2012). The discretionary management of accruals has thus become the focus of the large number of studies that attempt to identify earnings management by using models that distinguish discretionary accruals from accruals arising from the unbiased application of GAAP, known as ‘non-discretionary accruals’ (Ball and Shivakumar 2006, Dechow et al. 2010). 48

3.5.2.1 How accruals are used in earnings manipulation

Accruals are used to manipulate earnings because although earnings includes both a cash flow and accrual component (Mc Nichols & Wilson 1988, Sloan 1996), the cash flow component of earnings is less susceptible to manipulation through accounting practices (Dechow 1994), and management is therefore alleged to influence the more susceptible accrual component (Schipper 1989; Sloan 1996). 49 Although management can determine the timing of cash transactions to manage cash flow, they have little accounting latitude regarding cash transactions to alter earnings (Beneish 1997, 1998) because cash is verified against source documents. In contrast, managers have more scope to exercise discretion over accrual estimates, which flow through to reported earnings (Dechow and Schrand 2002; Dechow and Dichev 2002). For example, managers may choose different methods and life cycles for depreciating fixed assets and/or reduce the amount of expected bad debts, to increase current earnings (DeFond and Park 2001).50

48 _{Discretionary accruals also are referred to in the literature as abnormal accruals (e.g. DeFond and Park} 2001; Dechow, Ge and Schrand 2010) and ‘unexpected accruals’ (e.g. Healy and Wahlen 1999). These terms are used interchangeably in this thesis.

49 _{Sloan (1996) reports results that suggest that the cash flow component of earnings is more persistent} than the accruals component. This may imply that the cash flow component is less vulnerable to manipulation.

50 _{The literature identifies several specific accounts subject to accruals management, including: bad debts} (e.g. McNichols and Wislon 1988; Teoh et al. 1998); depreciation (e.g. Beneish 1998; Teoh et al. 1998; Young 1999; Keating and Zimmerman 2000); loan loss provision (e.g. Wahlen 1994; Collins,

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Moreover, the reversible nature of accruals makes them vulnerable to manipulation and allows managers to shift earnings between periods.51 The effect of accruals reverses in subsequent periods that by exercising discretion over judgement and estimates, managers influence not only current year earnings, but future earnings (Barton and Simko 2002; DeFond and Park 2001; Mulford and Comiskey 2002). Prior studies consistently document that in fundamentally poor years or in the initial year of a CEO’s tenure firms may bring forward expenses to the current period to ‘take a bath’52 and thereby create accrual reserves which are then reversed in the future to increase earnings (e.g. John, Land and Netter 1992; Elliot and Hanna 1996; Gill et al. 1996; Moehrle 2002; Baber et al. 2011; Dechow, Hutton, Kim and Sloan 2012). For instance, mangers may overstate bad debt allowance in the current period which will increase future period’s earnings when the over-provision is reversed. Conversely, managers may understate allowance for bad debts to improve current period earnings, which subsequently reduces future earnings when adjustments to the provisions are made (Dechow and Schrand 2002). Baber et al. (2011) and Dechow et al. (2012) assert that the speed at which past accruals reverse, affects the timing of managers’ earnings manipulation efforts. That is, accruals that reverse quickly (within one year) are more susceptible to earnings management.53 _{Therefore, the reversible nature of accruals} allows managers to manipulate earnings up or down between periods.

Managers also have discretion over the timing of when irregular accruals are recognised, which can be exploited to manipulate earnings (Roychowdhury 2006, Xiong 2006). For example, managers may delay the recognition of expenses such as Shackelford and Wahlen 1995; Beaver and Engel 1996; Liu, Ryan and Wahlen 1997; Kanagretnam, Lobo and Yan 2004; Fonesca and Gonzalez 2008; Bushman and Williams 2012; El Sood 2012); insurance claim loss provision (e.g. Beaver and McNichols 1998; Petroni, Ryan and Wahlen 2000; Beaver, Nelson and McNichols. 2003; Gaver and Paterson 2004; Browne, Ma and Wang 2009; Eckles and Halek 2010; Grace and Leverty 2011; Eckles, Halek, He, Sommer and Zhang 2011; Fiordelisi, Meles, Monferra and Starita 2013); tax expenses (e.g. Visvanatahn 1998; Lu 2000; Mills and Newberry 2001; Joost, Pratt and Young 2003; Dhaliwal, Gleason and Mills 2004; Phillips, Pincus, Rego and Wan 2004; Hanlon 2005; Francis and Rego 2006; Badertscher, Phillips, Pincus and Rego 2009); and asset write-offs/write-downs (e.g. Kinney and Trezevant 1995; Francis, Hanna and Vincent 1996; Nelson et al. 2003; Riedl 2004; Beatty and Weber 2006; Duh, Lee and Lin 2009; Allen, Larson and Sloan 2013).

51 _{Accrual reversals may represent both earnings management and genuine estimation errors, where an} accrual estimation error is the difference between the accrual estimate and the subsequent realised amount (McNichols 2002), and is not exactly the same as an accrual misstatement which is a GAAP violation (Allen et al. 2013).

52 _{Such behaviour occurs when earnings are already low that no accounting method will increase them to} the targeted earnings amount (Healy 1985).

53 _{Dechow et al. (2012: 276) suggest that accrual reversals should be included in earnings management} models to improve the test power as well as reduce misspecification arising from correlated omitted variables, provided the researcher knows the timing of reversal. Gerakos (2012) agrees that the model provides improvement to the customary models used to detect accrual-based earnings manipulation, although no guidance is given on how to identify the timing of reversals.

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writing down obsolete inventory and/or asset impairment if they wish to increase current period earnings.